The opportunity for development in the financial markets of the Gulf states has never been so clear and necessary as it is in its present climate, but the GCC needs to address reforms for the market to continue moving forward
The Gulf Co-operation Council (GCC) capital markets ' Bahrain, Dubai, Kuwait, Oman, Saudi Arabia and Qatar ' pose both a challenge and an opportunity for the very same reason: they are underdeveloped, even grossly so in some cases, in comparison to some of the emerging markets we see elsewhere in the world.
Never has the opportunity for development been so clear and necessary. This is a region that is beginning to appreciate the importance of having a more developed and sustainable capital markets proposition. And whether in the more liquid markets such as Kuwait or less liquid markets such as Oman, liquidity continues to be an issue across the board.
The GCC's capital markets' insulation has shielded them from much of the turbulence we have seen around the world over the past 10 to 30 years. However, this has also contributed to their underdevelopment. Within this microcosm, we have seen unique opportunities present themselves and these opportunities have been mainly in equities.
The GCC has always been a wallflower at the capital float party. They have never really been on any maps of international investors. Most of the money invested in the GCC is generated from within.
Both emerging markets fund managers and direct investors have the GCC on their mental investment map. Each of the six countries have plans for global integration on the trade front and the investment front. The social programmes require government support of the capital markets to help fund those plans and increasingly the government is interested in attracting a larger share of international money. However, people will not be encouraged to invest in an undeveloped market and the undeveloped market will not develop unless there is capital flow into the market.
GCC capital markets are eventually going to prove a source of reward for those managers who are brave enough to break that cycle. We believe mover risk is coupled with early mover advantage.
Oman has had an impressive drive at increasing corporate governance over the past few years. Kuwait has liberalised a market that has previously been unwelcoming for foreign investors, even Gulf-based investors. Qatar has gone international on its drive to borrow, to build a benchmark and to build a history of dealing with international money. Dubai has been and is currently going through a controversial move towards liberalising the land and property ownership and Saudi Arabia is reopening its oil sector.
These are not necessarily comprehensive moves, not necessarily holistic, but these are indications that we have never seen before, aimed at making a more agreeable terrain for capital.
One market that is interesting is Saudi Arabia, which has an economy double the size of Malaysia's, but with a market half its size. GCC markets have actually been one of the few markets that have fared well during the first half of 2002. The markets have been up over 13%.
Comparing the six markets, Saudi Arabia has the largest market cap, which, at $28bn, sounds like a fairly respectable number. However, taking into account just the free float, it is closer to 10% of that figure due to institutional and government holdings. To various degrees, this can be said about the other markets.
Changes are occurring in the free-float problem, but unfortunately not imminent changes. The governments are far too comfortable. They are too happy they have a certain dividend coming in from their public holdings. Many bureaucrats are also playing God with companies as they sit on boards representing these governments. The catalyst will eventually be when the government realises market reform is more important than their holdings and dividend cheque at the end of the year.
If the governments become cash strapped, which will certainly be the case in Dubai some day, then while they are able to borrow, they will also have a lot of equity in these companies that will eventually be too juicy not to cash in. So those will be the drivers in the future but we are nowhere near this scenario, by any means. The governments are still convinced holding onto these equities is the way forward.
The Kuwaiti market is the closest you will find to a non-emerging market. But while it is the most developed, sophisticated and liquid, it is also the most susceptible to volatility and at the moment, sensitive to the political situation. Kuwaitis are well-known market operators and are revered and looked up to throughout the Gulf.
Bahrain is a small and liquid market. It has good levels of regulation, but is hindered by the small local economy. The UAE is a fragmented market consisting of an over-the-counter market as well as two small floors. Regulation is very weak and the float is small.
Saudi Arabia is the largest market by far but dominated by the banking sector and is somewhat closed to foreign investment. The Omani market is well regulated, but low on liquidity and size. There is a lack of a solid underlying economy which also hinders the ability to develop the market. Qatar is small, but poised to boom along with the economy. One of its hindrances is that it is dominated by a single stock ' Qatar Telecom ' and it is prone to sentiment-driven investment.
The Dubai International Financial Centre is an interesting initiative, however it is still in its early days and it has strong competition from Bahrain. On a side note, I do not think there is enough variety in the region to warrant two financial centres and Dubai has for one reason or another kept away from developing a financial centre until now and it is doing so probably out of necessity in terms of looking at diversifying its economy.
Whether the established centre, Bahrain, is going to fade or not depends on whether it puts up a fight or integrates its very developed system. It becomes a political issue rather than an economic issue and so could go either way. On the economic side, if the Gulf can take two financial centres then this is a very good sign and it means we have matured enough to be able to have enough work for two centres.
The Debt Markets
On the debt side, the GCC has not matched the boom in debt instruments we have seen in other emerging markets over the past 20 years. Saudi Arabia is primarily an internal debt market. Kuwait and Bahrain are the most developed but when you compare it to equities, it is a relatively small part of the overall picture. Debt in the eyes of local investors including institutions is viewed more as a holding rather than a trading security, therefore secondary markets and thus liquidity are almost non-existent. Demand for debt is dormant but existing. We believe there is a lot of room for growth in debt.
There is a growing belief within governments that you can borrow even if you do not need to borrow where debt issuances are concerned. This was not the case in the past. The one area I would like to see more work on is the creation of a local shadow of what is happening internationally as far as debt is concerned.
Saudi Arabia has a burgeoning local debt market, but at certain points in time has also had difficulties on repayment of local debt. This was mainly due not so much to a function of creating markets than an ad hoc solution of payment problems that they had. So it was a mismanagement issue, rather than part of a plan to develop a debt market.
We have also seen a drive towards borrowing. The government of Dubai is going down this road and borrowing through debt markets going forward ' corporations will not be far behind the government.
Inefficient and incomplete regulatory frameworks place a great burden on private sector innovators who try to figure out ways of improving and developing new products and ideas but continue to hit walls ' mainly regulations that are not of this place and time. The new regulations tend to be reactive and do not seem to come from single comprehensive plans. In many GCC states, regulation is multi-tiered and confusing. The UAE is a prime example of this. Block holding of shares by the government stifles liquidity. The government, without exception in all six states, is a significant holder of equities. Times have changed, but the governments' role has not.
Finally, there are no indications of divestment in most countries. Kuwait perhaps is one example, however it has also been a half hearted effort.
Institutional investors play pretty much a similar role to that of the governments. By institutional, I lump together institutions, corporations, family businesses, high net worth individuals ' indeed any large shareholder. They are holders, not traders, who buy and keep.
These large holdings coupled with the relatively small size and liquidity of the market give more power than should be the case. Also there is a lot of foot dragging by these institutional investors who are very influential on decision making.
This is simply because the present pattern is not aggressive ' it suits the requirements and needs of an evolutionary, rather than a revolutionary, approach to market reforms. On the demand side, there are a lot of institutions who tend to keep their financial market operations in-house, which also hinders the development of professional, specialised houses.
All this leads to higher capital costs especially for smaller companies and smaller operators. There is less diversified growth because many companies do not have access to capital, or if they do they get it through financial markets,with unfavourable terms. Opportunity for cross-border private sector partnerships are also hindered by investment restrictions. It is not easy for a company out of Oman to invest in the UAE or of the UAE to invest in Qatar.
There are wide differences in P/E ratios between the various markets. This is mainly due to the unique nature of each of the markets. For example, all the markets have been through a testing time over the past four years. However, some of the markets have bounced back much better over the past year than others. Bahrain has not moved much while Kuwait has moved heavily. Kuwait's P/E ratios, for example, have increased because Kuwait has got a lot of event-driven cash in terms of the government divesting some of its interests through mutual funds and due to reparations finally hitting public companies from the UN compensation from the war. So, those are single events that have moved the market slightly.
The UAE traditionally has a higher P/E market than its neighbours simply because it is a demand-driven market ' there is always more demand than supply.
In broad terms we need to see serious reforms in the GCC. We need the establishment of solid foundations for the convergence of the markets as they are simply too small to stand alone in this modern world, which is headed towards more integrated economic blocks. In addition, the opening of markets is essential ' intra-Gulf traffic to start with and beyond that to international traffic. The governments' role in shareholding needs to be redefined. Liquidity needs to be created, whether through debt markets or through a more active primary market. The encouragement of the private sector to bring new products to market is important. There is no role of facilitator at this point in time.
A secondary bond market should follow soon after the development of a primary market. Development of benchmark bond issues will enable the rest of the economy to price itself. A lot of these benchmarks today are either alien to the locally-based risk, or alien to activity within the domestic economy. Clearing and settlement needs to be improved in order to enable these markets to handle capacity.
So why invest in the GCC at all if this is the situation? The GCC equity markets are not correlated, at least until now, with other emerging markets or with developing markets. Therefore they represent an excellent opportunity for diversification and represent an opportunity at a time in the global economic cycle where there are not many areas to go into. Additionally many blue-chip GCC companies are presently available to foreign investors although the transparency is not what a foreign investor will be accustomed to. However, comparatively they are in a much better than we were even three or five years ago.
Further liberalisation is expected shortly. Consequently you will have a window of opportunity of an early mover advantage at this point in time. Liberalisation includes both better regulation and a more active government role and includes also an increase of liquidity in the market. As far as ratings are concerned, all six GCC countries have favourable ratings and have favourable macroeconomic situations. All are blessed with that ultimate provider of current account surpluses ' oil.
Investors are worried about the political risk in the region that the direction of reforms will change, even go backwards. But this is a risk you have everywhere. The issue is, how important reforms are in the countries. In all six countries, reforms have never been more important than they are today and they have never been more important as an element in the development plans of these economies. This was not an issue 20 years ago. In the 1970s there was a lot of oil and a small population ' you could spend out of pocket. This cannot be done today so other options need to be considered. We now have a more sophisticated economy ' it is not a simple one commodity economy as it was 30 years ago. These are all issues that point towards the need to create a more comprehensive and more professional financial scene.
One emerging opportunity we believe will be the Dubai International Financial Centre ' it is early days, but the government of Dubai has set out to establish a professional and forward-looking centre of excellence for financial services.
Many blue-chip GCC companies are presently available to foreign investors although the transparency is not what a foreign investor will be used to.
In all six countries, reforms have never been more important than they are today and they have never been more important as an element in the development plans of these economies.
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